Hamish McRae: The mountain top is shrouded in mist: could rates have some way to climb?
The Bank of England must try to avoid a housing bubble
Sunday 22 October 2006
We are going to get higher interest rates, starting next month. The question is, how much higher?
It was always on the cards, but in the past few days a couple of bits of evidence have made it certain. One was the first estimate for third-quarter GDP, which shows that during the three months to the end of September, the economy continued to grow at an annualised rate of just under 3 per cent. That pulled up the 12-month rate, as you can see from the first graph.
What seems to have happened is that manufacturing made a modest recovery and that supported the continuing steady growth in services. Such a performance does not of itself warrant an increase in rates. But it does mean there is no domestic reason why there should not be a rise were the Bank of England's Monetary Policy Committee (MPC) so inclined. And clearly it is.
The other was the evidence of hawkishness from the MPC's October meeting. Though the overall vote was for no change, two members of the committee voted for an increase. Inflation is running at 2.4 per cent, above the 2 per cent target, giving a prima facie justification.
The balance of the committee clearly felt it better to wait for the next meeting, when the new Inflation Report will be published, and that makes sense. But unless the report contains something quite unexpected, it will be 5 per cent rates next month.
At one level, this is all quite encouraging. Growth this year has been stronger than many, including the Treasury, expected. Employment has continued to rise, though thanks to the increased size of the workforce - from immigration and older people returning to work - unemployment has risen too. The housing market has recovered, with prices now up by an average of around 8 per cent year-on-year, which should help sustain consumer demand. There was a downward blip in retail sales in September, but most people don't seem to think that says anything alarming about consumption in general.
But the buoyancy in the property market does point to the perils ahead. If wages go up by 4 to 5 per cent a year and house prices by 8 to 10 per cent, housing becomes 4 to 5 per cent less affordable every year. Already the ratio between prices and average income is the highest it has ever been. The further that gap widens, the greater the danger of a sudden fall. This has not happened yet, leaving the many economists who warned about the danger feeling a bit uncomfortable. But that does not mean it won't happen in the future. (My own view has been that a plateau is more likely than a slump.)
The point here, which is always worth repeating, is that the Bank does not officially have any policy on house prices; interest rates are set with regard to future inflation of goods and services. Nevertheless, the Bank has an overriding responsibility for the stability of the country's financial system - a role that long predates the founding of the MPC. So if house prices are likely to lead to financial instability, as falling prices did in the early 1990s, it has to be concerned. It must try to avoid a housing bubble.
In any case, other factors are at play in rate-setting decisions. These include the extent to which the prices of current goods and services are held down by external forces, which might fade, and not by domestic ones. Of these forces, the main one is the impact of China and India (and to some extent Eastern Europe) on the price of traded goods and, to a lesser extent, traded services.
The UK has experienced one example of the Eastern Europe effect: immigration has held back wage inflation. But internationally, the act of offshoring production, or simply the threat of it, is keeping down the price of things as diverse as electronic equipment and online computer support. Can we rely on this downward pressure to continue?
Well, yes - up to a point. But the particular impact of a large increase in the workforce has been a one-off. Some further immigration will come from Romania and Bulgaria, but as other EU job markets gradually open up, it may be that at least some of the new migrants will go elsewhere. Other forces helping to restrain inflation, such as the fallback in oil prices, may reverse themselves. So the Bank would be wise to lean a bit harder against inflation.
Is 5 per cent the top level for rates? A Reuters poll of City economists published on Friday showed that around one in four expect another rise to 5.25 per cent in the early part of next year.
Suppose, though, that is not the peak. I do not have a coherent argument to support this, but I find myself wondering if the coming peak could be rather higher still - say 6 per cent.
This might happen for several reasons. One possibility is that the US slowdown expected next year isn't too severe. Another is that growth in China and India races on despite efforts to slow the pace.
But the big reason for thinking rates might have to go up quite a bit more is that even 5.25 per cent will not be enough to check either UK growth or the housing market.
Growth is still being pushed up by public spending. Each year, the Chancellor ends up borrowing more than the number he first thought of. In the middle graph, you can see the deficit on the current budget, the dotted line being this fiscal year and the solid one last year. It looked as if we were succeeding in borrowing less than last year, but note the dotted line is back to the solid one. The spot shows where the Government hopes to get to by the end of the year. That target no longer seems achievable.
So what will happen? Higher taxes? A clamp on public spending? Or might the Treasury, under new management, just carry on borrowing? My guess is that it will. Overall debt as a percentage of GDP (right-hand graph) is still well below the level inherited in 1997. I can't see a Brown-led government implicitly accepting that he has been ill-disciplined with the country's finances; tax rises and spending cuts would give that message. His golden rules will be revised again to make it look OK.
So fiscal policy will keep pushing the economy on, leaving monetary policy to rein it back.
There are a host of reasons why this might be a false alarm - maybe mortgage borrowers will escape with the 5 or 5.25 per cent peak. But it might be wise to do the sums just in case rates do indeed go higher.
Better to plan for the worst and it not happen, than the other way round.
Boys from Brazil are changing perceptions at the acronym club
When discussing the emerging "BRICs" economies, we hear a huge amount about India and China and, recently, quite a bit about Russia too. Brazil, the other member of the acronym club, does not feature so much as an economic story. Yet in recent years it has been performing considerably better. Growth is around 3.2 per cent this year, with rather more predicted for next.
Inflation, once stratospheric, is running at 4 per cent. And the potential for faster sustained growth remains. Brazil's President, Luiz Inacio Lula da Silva, recently predicted that the country's growth rate would climb to 5 to 6 per cent in the years ahead.
But then he is running for re-election. There is a run-off against his rival, the former governor of Sao Paulo, Geraldo Alckmin. Mr Alckmin is seen as more business-friendly, whereas President Lula was once a left-wing trade unionist - though he has certainly been fiscally conservative in office.
Although the first-round vote was well in the President's favour, at 48.6 per cent against 41.6 per cent, apparently the run-off is likely to be very close. Three things are interesting here. One is that prudence seems to be the new norm. Inflation in the emerging markets taken as a whole has fallen sharply over the past decade, and in a way all Brazil is doing is following this path. But significantly, the old idea that inflation was something to be lived with rather than tackled is now dead.
The second is that President Lula has made quicker economic his main concern. Citing that 5 to 6 per cent figure is in one sense stating the obvious.Brazil ought to be moving faster.
The third follows on from that. The Bric concept is changing perceptions in both India and Brazil (Russia is slightly different). China has become the benchmark for performance, a beacon for other larger developing economies. If China can do it...
Economic performance is related to self-image. People used to talk of the "Hindu rate", suggesting India could not grow faster than 3 per cent a year. Meanwhile, Latin American inflation was a given - it was what these countries did. China's economic take-off has changed all that. It has changed perceptions of the possible.
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